EUROPEAN UNIVERSITY INSTITUTE DEPARTMENT OF ECONOMICS
EUI Working Paper ECO No. 98/33 An EMU with Di®erent Transmission Mechanisms? Giorgia Giovannetti and Ramon Marimon
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°1998 G. Giovannetti and R. Marimon Printed in Italy in December 1998
European University Institute Badia Fiesolana
I-50016 San Domenico (FI) Italy
An EMU with di®erent transmission
mechanisms?
¤
Giorgia Giovannetti
Universitµa di Firenze and European University Institute
Ramon Marimon
European University Institute,
Universitat Pompeu Fabra, CEPR and NBER
July 1998
Abstract
We develop and compute a dynamic equilibrium model where economies di®er on the relative e±ciency of ¯nancial intermediaries and, therefore on households portfolios and currency holdings. Our model economies have some of the features of the di®erent ¯nancial structures in countries of the European Union and respond to monetary shocks in a way similar to the observed responses, which we also esti-mate. It follows that, if di®erences on the relative e±ciency of ¯nancial intermediaries persist in a monetary union, con-°icts of interests in the pursuit of a common monetary policy can arise.
¤We would like to thank Elena Gennari and Christian Upper for research assistance
and Pedro Teles, as well as participants in seminars, at UPF, EUI, UCLisboa, OECD, SED and SET, for comments. This research project has taken place within the 1996-97 European Forum of the EUI on \The Political Economy of an Integrated Europe." Giorgia Giovannetti acknowledges ¯nancial support by MURST.
Non Technical Abstract
In spite of the high level of economic and ¯nancial integration in Europe in the last ten years, there are still marked di®erences across countries regarding: (1) e±ciency of the banking sector; (2) portfolios holdings and ¯rms' ¯nancing, and (3) output and price responses to monetary shocks. This paper develops an equilibrium model with limited participation, which is consistent with these three facts.
In the paper, we study two economies (which can be identi¯ed with France and Germany) di®ering for the degree of e±ciency of the banking sector (fact 1). As a result, agents in the two countries hold di®erent portfolios and ¯rms are ¯nanced with a di®erent mix of debt and equity (fact 2). When we calibrate the model for the two economies, impulse responses to a monetary shock di®er in a way similar to the observed impulse responses for France and Germany (fact 3).
We then study the e®ect of integrating these two economies in a Monetary Union. We ¯nd that, when countries are in a monetary union, and to the extent that the di®erences in the ¯nancial systems persist (likely to happen in the ¯rst stage of EMU), endogenous preferences for monetary policy may be even more diverse than when countries are sepa-rated. In particular, the same monetary policy gives rise to redistribution e®ects not present if countries were more isolated.
Finally, we estimate VAR for France and Germany over the period 1973-1997 and we show that the output responses to monetary shocks are very similar to the theoretical reactions derived from our model and similar to other existing result.
1 Introduction
The transmission mechanism of monetary policy may be de¯ned as the ways in which monetary impulses from the central bank a®ect output and prices. Changes in monetary policy are transmitted to the real econ-omy through various channels, each of them can consist of several stages. Hence, national transmission mechanisms are likely to be di®erent: dif-ferent channels may be at work in di®erent countries and the intensity by which a monetary impulse is transmitted can vary, even substantially. But di®erences in national monetary transmission processes between Eu-ropean countries, in turn, are likely to a®ect the magnitude and timing of the price and output e®ects of alternative monetary policies of the European Central Bank (ECB). They may also have implications for the scope and nature of policy coordination in the current state and for evaluating possible bene¯ts of joining a monetary union for individual countries. Hence, even in the absence of cyclical divergences and dif-ferences in policy predif-ferences across countries, the stance of monetary policy to be followed by the ECB can be a source of con°icts between member states of EU. This, in turn, may imply a decrease of support for the monetary policy of the ECB1.
In what follows, we do not enter the debate on the relative impor-tance of the di®erent channels of transmission of monetary policy. We believe that monetary policy a®ects output and prices (at least in the short to medium run) and may do so through di®erent channels, not mutually exclusive, simultaneously at work and likely to reinforce each other. Our aim is to focus on the fact that a certain (common) monetary stance may have di®erent macroeconomic consequences from one coun-try to another. While the existing literature has mainly analyzed partial equilibrium models emphasizing speci¯c channels or, when approaching the issue in a general equilibrium framework, has concentrated on liquid-ity e®ects, we show that the di®erences in the speed and magnitude of
1For instance, the ERM crises of 1992-93 highlighted cross-country di®erences in
the monetary transmission mechanism which seemed to substantially a®ect the cost of maintaining the parities.
a monetary impulse into economic activity depend on di®erences in the ¯nancial structure, on di®erent role of ¯nancial institutions and on di®er-ent portfolios composition of households and ¯rms in di®erdi®er-ent countries as well as on di®erent liquidity constraints. In this framework, when (or if) a common monetary policy is implemented (and to the extent that the e®ects of it are di®erent for di®erent countries) unwanted distortions and/or con°icts may arise.
An empirical (statistical) examination of the role of banks, stock markets and portfolios compositions of the European economies suggests that they di®er signi¯cantly in many ways. First of all, in some European countries (e.g. UK) markets for privately issued debt and stock markets are highly developed, so that bank credits are (almost) perfect substitutes for bonds, while in others (e.g. Italy and Germany) these markets are less developed and bank credit and loans cannot be seen as substitute sources of ¯nancing. This can substantially a®ect the liquidity of markets and the ways in which a money injection (or reduction) is translated into households and ¯rms. There are also di®erences in regulations, in procedures, in the relative use of short term versus long term ¯nancing, in the relative share of ¯xed versus °oating rates, in the degree and composition of indebtedness of ¯rms, households and governments. Also, the ¯nancial structure of the di®erent countries has evolved di®erently in the last two decades, with changes in the competitiveness of the banks and growth of non bank ¯nancial intermediaries in some countries but not in others, with di®erent evolution of stock markets and changes in the composition of assets and liabilities of households and ¯rms. At the same time, mainly in the last decade, capital markets have become more integrated and some EU countries (e.g. France and Italy) have been compelled to lift previously operating administrative controls.
There are, of course, some areas where convergence is likely at the outset of a Monetary Union. First of all, the convergence of in°ation rates should lead to a more uniform pattern of short-term versus long term ¯nancing across countries, at least to the extent that these dif-ferences have emerged as a result of di®erent in°ation records; also the increased competition across ¯nancial intermediaries should imply that
the pass-through of changes in market rates to lending rates should be-come more similar. We maintain that some structural di®erences will stay; the transmission of monetary impulses to the real activity and the distribution of gains and losses amongst EMU members is likely to de-pend on these di®erences.2
Our aim is to capture some of the existing di®erences in the ¯-nancial structure and portfolios compositions of European countries in an equilibrium model where economies di®er for the relative e±ciency of the ¯nancial intermediaries (i.e. households portfolios and currency holdings) and to study the implications of a common monetary policy for di®erent economies under two di®erent regimes: with and without a Monetary Union. We ¯nd that the same monetary policy gives rise to redistribution e®ects, not present when countries are isolated.
The paper is organized as follows: Section 2 presents some stylized "facts" emphasizing the heterogeneity of ¯nancial markets in 4 big Euro-pean countries: Germany, France, Italy and the UK. Section 3 outlines a simple dynamic equilibrium model which allows to account for (at least some of) the detected di®erences and analyze the consequences for the transmission mechanism of monetary policy. It is an overlapping gen-eration model with cash in advance constraints. A monetary expansion induces a decrease of the interest rate and an expansion of output through a substitution of consumption of cash and credit goods and revisions of plans about deposits and assets holding. The di®erent e±ciency of the banking system implies di®erent liquidity constraints across countries, so that the degree of substitution and therefore the real e®ects are di®erent. Contrary to most G.E. models, using this framework, we get persistence of an independent shock. Section 4 calculates the theoretical impulse responses for an interest rate shock, under di®erent scenarios (autharkic countries, Monetary Union, the same and di®erent cash/deposit ratios). Our model economies, which we call for convenience France and Ger-many, have some features of the true ¯nancial structure of France and
2Of course di®erences exist also within the national borders. They tend, however,
to be smaller, since between countries there are more di®erences in regulations and institutions.
Germany and respond to shocks in a way similar to the observed response. Section 5 presents some VAR estimates of the e®ect of an interest rate shock on output of France and Germany over the 1973-97 period and Section 6 concludes. The Appendix contains the description of the data set and unit root tests on the variables used in the VAR estimation.
2 The heterogeneity of European ¯nancial
markets: Some stylized "facts"
Despite the implementation of the single market from 1992, despite all the changes brought about by deregulation, capital liberalization and technological innovation in the last two decades, the ¯nancial systems of European countries are still characterized by a high degree of heterogene-ity. Furthermore, their convergence over time has been quite limited and some of the fundamental di®erences existing in the 1980s have survived all the changes. In the following we point out two related di®erences in the ¯nancial markets of France, Germany, Italy and the UK3, which we
believe can a®ect the transmission mechanism of monetary policy and therefore induce con°icts in the monetary policy decisions of the Euro-pean Central Bank: the degree of development of ¯nancial markets and portfolio decisions of households, ¯rms and institutional investors.
2.1 The degree of development of ¯nancial markets:
There are two main channels through which funds °ow from savers to ulti-mate borrowers within each economy. Savers can invest directly, through the purchases of securities such as stocks or bonds issued by a non ¯nan-cial corporation (direct ¯nance) or their °ow of savings can beinterme-3While here we concentrate on these four countries, Gennari and Giovannetti, 1998
provides data on the ¯nancial structures, liquidity constraints and portfolio choices for 15 EU countries. It must be noticed that, in Europe, there is also a signi¯cant heterogeneity regards the links between the central banks and the ¯nancial sector, cf. Giovannetti and Marimon, 1995.
diated by ¯nancial ¯rms (indirect ¯nance). Direct ¯nance takes place in capital markets. The prevalence or absence of ¯nancial intermediation in a national economy structures the relationships within the private sector. European countries are very di®erent with respect to the mix of direct and indirect ¯nance that characterizes their ¯nancial systems. Ac-cording to European Economy (1997) "This is mostly explained by the relative role of domestic banking: countries with high ¯nancial interme-diation equally show a high degree of banking intermeinterme-diation" (p.10). As shown in Table 1, Germany is characterized by a much higher degree of ¯-nancial intermediation (more than 50%) and bank intermediation (above 80%) than any other European country. Because of the dominant role of bank intermediation, many ¯nancing demands which could be met by bonds or equities are provided by bank loans. Accordingly (or because of) the most e±cient banking sector amongst European countries -no matter what criteria is used to assess e±ciency4 is in Germany. The
ex-isting data, not fully harmonized and therefore to be used with caution, show that classical banking intermediation (i.e. taking deposits from con-sumers and making loans to people and ¯rms) is still the main channel of saving and investment in all EU countries. However, there are relevant di®erences in the use of loans versus shares, which re°ects di®erences in market capitalization. In Germany, security markets are underdeveloped with respect to other major EU countries (namely France and the UK, see Table 1). In1995, stock capitalization represented only 29% of GDP in Germany versus almost 150% of GDP in the UK (it was 39% in France, and 22% in Italy, see again table 1). The number of ¯rms quoted in the stock market is much larger in the UK and in France (both in terms of consistency and new quotations) than in Germany and Italy and new issues are particularly low in Germany5. As a result, equities issues by
4Di®erent crietria can be applied to assess the e±ciency of the banking sector.
Gual and Neven (1993) suggest to evaluate the sta® costs per deposit, which give information on the cost side of intermediation, or the net interest income per deposti, which also allows to account for possible lack of competition.
5In Germany the capital market was fragmented into eight independent regional
stock exchanges till fairly recently and this can at least partially explain the di®erences in the degree of stock market capitalization. Also, German banks conduct both direct
¯rms are a signi¯cant share of GDP in the UK and France (respectively 65 and 70% in 1994) but almost irrelevant in Germany (25% in 1994)6.
It must be also noted that most European stock markets mainly trade domestic equity and that ¯nancial integration has not changed this type of segmentation. Only in London foreign shares are usually traded (2/3 of total trading in London is foreign shares, which amounts to around 95% of total EU trading in foreign shares).
Table 1 here
2.2 Portfolio decisions
The di®erent mix of direct and indirect ¯nance re°ects in portfolio de-cisions of the private sector. Even though, as far as households are con-cerned, the share of deposits over gross assets has fallen everywhere in the last twenty years (table 2), the extent of the fall is very di®erent: in Germany deposits were 59% of gross assets in 1980 and still constitute 45% of households ¯nancial assets in 1994, while, for instance in France they dropped from 59% to 32% and in Italy from 58% to 29% (households savings has been fairly stable in this period, despite cyclical °uctuations). While bonds have remained fairly constant between 1980 and 1994 (see Table 2), direct securities holding have been in general declining (France represents an exception). Transactions costs in securities markets (in-cluding the bid-ask spread) makes it di±cult for households of average means to diversify via direct securities holdings especially because liquid-ity is low in the case of direct holdings. Hence a feature of UK, Germany and Italy has been that the share of households portfolios held in the form of securities has tended to decline (table 2) while the proportion of equities and bonds held via institutions has tended to increase (see again
and indirect ¯nance and have therefore made the capital markets largely endogenous to the banking system. To the extent that industries have access to the securities market, their access has been governed by banks.
6There also seems to be a correlation in the 4 European countries between equity
market capitalization and the size of ¯nancial institutions, but a discussion of this issue is outside the scope of this paper. Cf. Davis, 1996.
table 2). Only in France direct holding of securities passed from 14% in 1980 to 32% in 1994 (possibly because of a successful privatization process), with institutional investors also increasing their weight (from 7% to 29%). This seems to indicate that in France households tend to di-rectly supply funds to the ultimate borrower even if this means to bypass the ¯nancial sector.
Table 2 here
As far as non-¯nancial ¯rms are concerned, there has been an over-all increase in ¯nancial liabilities in the last two decades which has been covered with di®erent mix of debt and equities. The existing data (OECD ¯nancial accounts statistics) show particularly large di®erences in the use of loans versus shares (see Table 3). Loan ¯nancing is particularly high in Germany and substantially lower in France and the UK (when consid-ering loans as proportion of gross ¯nancial assets, respectively (50%, 28% and 12%). Hence, the role played by German banks in lending to non-¯nancial corporations is substantially bigger7. Furthermore, over time,
the loan ratio declined substantially in the UK and remained fairly con-stant in other European countries. The equity ratio, on the other hand, has risen everywhere except in Germany, reaching the remarkable value of 70% in France and 65% in the UK, while staying at a mere 25% in Germany.
Table 3 here
Structure of equity holdings, however, has tended to move away from the household sector and towards institutional investors everywhere apart from France, where, as we said, households hold directly substan-tial shares of equities (see Table 4). In Germany, for instance, ¯nancial institutions own 30% of the total amount outstanding (14% are directly owned by banks and the remaining 16% by other ¯nancial institutions)8.
Table 4 here
7In 1991 more than 60% of bank loans were provided in a long term form in
Germany, while the same ¯gure was around 50% for the UK, cf. OECD Non-Financial Entrerprises Financial Statements, 1991.
8Many bank customers, furthermore, keep their shares deposited with banks and
2.3 Monetary aggregates
Per capita currency holding (expressed in common currency, i.e. dollars) di®ers substantially amongst European countries despite similar levels of development9. Germany has a much higher ¯gure than other European
countries (with the exception of Switzerland), possibly because of the large holdings of DM abroad. Theoretically, the currency holding should decrease over time as a result of ¯nancial innovation and use of electronic money, but in Germany if anything, currency holding has increased.
Composition of monetary aggregates also varies substantially in Europe. For instance, the ratio of cash to the di®erent measures of money supply (respectively, M1, M2 and M3) is higher in Germany10
(see Table 6) than in the other countries.
Also, o±cial reserves are lower in France and the technical features of the reserve requirements di®er signi¯cantly across countries, re°ecting functional and structural di®erences between national ¯nancial systems. The main di®erences are re°ected in the de¯nition of bank liabilities (type and currency), the rates applied, and the existence and level of remuner-ation. In Germany for instance, a 5% reserve requirement is levied on sight deposits and 2% on other types of deposits, without remuneration. In France, the ratio is 1% on sight deposits, and 0,5% on other types of deposits, also not remunerated. In Germany, the required reserves in 1994 were 1.3% of GDP and in France only 0.1%. This is likely to a®ect the costs of the intermediation.
Table 5 here
These di®erent characteristics of the ¯nancial systems obviously
9The presumption is that per capita currency holdings di®ers with di®erent level
of developments. In particular, less developed countries have a lower average level of currency holding, also because of unstable environment. However, the big di®erences existing between countries with similar levels cannot be explained merely by reference to di®ering payment habits and rates of in°ation.
10It must, however, be noted that Eastern European countries use DM (and no
other European currency) and this can impart a bias on the total amount of cash, cf. Seitz, 1995. Overall, Seitz concludes that roughly 40% of the German money supply is held abroad.
re°ect in empirical analysis of the transmission mechanism, but do not translate in clear-cut conclusions about the likely impact of a monetary shock. At the empirical level, in fact, the di®erent characteristics of a country in terms of ¯nancial structure can have o®-setting e®ects11.
At the theoretical level, the work on the transmission mechanism has mainly focussed on limited participation models (see for all, Christiano et Al, 1997), without emphasizing the possibility of di®erent ¯nancial structures.
Having in mind that the mix of direct and indirect ¯nance is very di®erent in the four major European countries, that the ratio cash to monetary aggregates also varies substantially, we propose a limited par-ticipation model where we allow for di®erent ways of saving and ¯rms' ¯nancing (which is the endogenous result of di®erent e±ciency of the ¯nancial sector across countries). This is the object of the next section.
3 A model with ¯nancial diversity
We develop a model that tries to incorporate some of the features that, as we have done in the previous section, can be identi¯ed as potential sources of diversity {and con°ict{ in the way that the Transmission Mechanism may work in the early stages of the EMU. The model is an Overlapping Generations Model with Cash-in-advance features. The OLG structure allows for alternative savings decisions. In particular, agents live for three periods, receive an endowment in their two initial periods and consume in their last two periods. They can diversify their portfolios between outside money (cash), bank deposits and equity, in the form of asset holdings of an underlying technology, that {after two periods{ realizes a positive real return. There is no uncertainty and Cash-in-advance con-straints guarantee that the {return dominated{ outside money is being held by households. Nevertheless, economies may di®er in the extent that
11For instance, sluggish adjustment of bank lending rates can protect ¯rms from
shocks but banks can ration credit (non price rationing) and amplify the e®ects of a shock.
goods must be purchased with cash. Agents can get a positive return on their savings by either making deposits in ¯nancial intermediaries or di-rectly holding the two-period asset. Whether they didi-rectly hold assets depends on the relative e±ciency of the banking system, another feature that will di®erentiate our economies. However, even with relatively inef-¯cient banking systems, agents will typically use ¯nancial intermediaries to obtain one-period returns.
The ¯nancial intermediaries, resembling the behavior of banks, ac-cept funds from households and return them to the household in the form of interest and principal payment. Financial intermediaries use their de-posits (and, possibly, monetary injections) to purchase two-period assets (as if they were lending to ¯rms). Given that they are in¯nitely-lived in-stitutions they can provide households with one-period returns at a cost. Given that there is perfect competition in the sector, ¯nancial interme-diaries' returns correspond to the outside asset return net of operating costs. Banks account for indirect channels of supply of funds; the stock market on the other hand, is an example of a direct channel, since it lets households to directly purchase assets. As in most developed economies, central monetary authorities deal primarily (uniquely, in our model) with ¯nancial intermediaries and, therefore, new money enters the economy by an injection from the monetary authority into the ¯nancial interme-diaries. Government bonds and open market operations can easily be incorporated in our model but, for simplicity, we do not include bonds and we limit our analysis to the case an exogenous injection (subtraction) of cash to (from) ¯nancial intermediaries.
With respect to the stylized facts previously discussed, our model economies could represent, broadly speaking, France (and the UK) and Germany (and Italy). As we have seen in Section 2, in the former house-hold directly house-hold assets (shares) and, in general, they do not channel a large part of their saving into deposits. In the latter, on the other hand, indirect channels are the norm. Households loan to the ¯nancial intermediaries their money and get in exchange a return.
3.1 Goods, assets, households and ¯nancial
inter-mediaries
There is a continuum of consumption goods, exogenous endowments, and a real asset giving a return of R2 after two periods12. Consumption goods
only di®er in the form on how they can be purchased. In fact, real assets and endowments can be {without costs and linearly- transformed into consumption goods, independently of their type. One can think of our economies as having goods in di®erent locations where some locations (e.g. street vendors) only accept cash while others are willing to sell for what, e®ectively is, credit (e.g. stores that accept debit cards, checks or other forms of credit). In terms of consumption, however, the agent is indi®erent on where the good is being purchased. An agent of generation t (born in period t ¡ 1) only values consumption in the last two periods of his life. That is, household's preferences are represented by
U(c1t) + ¯U(c2t) (1)
where c1t is {the average{ consumption in the intermediate period of his
life and c2t of his last period. The utility from cash and credit goods is
given by: U(c) = Z ° 0 u(ci)di + Z 1 ° u(ci)di (2)
where ° is the parameter indicating how goods can be purchased13.
Goods in the range (location) [0; °] can only be purchased with cash while goods in the range [°; 1] can also be purchased with credit14.
12R2 denotes the real return net of transactions costs. These can be di®erent for
¯nancial intermediaries and for individual agents, as well as they can di®er across di®erent economies.
13We make the standard concavity and di®erentiability assumptions. That is, u0>
0; u00 < 0:
14As we have said, ° is one of the parameters that will di®erentiate our economies.
It should be noticed that this formulation allows for a simple characterization of a richer transactions technology, by making ° endogenous (e.g. a function of e®ort and society's technology). Here, however, we consider ° an exogenous technological
In period t ¡ 1 an agent of generation t has the following budget constraint:
M1t + D1t + pt¡1at · pt¡1!0 (3)
where !0 is the ¯rst period's (average, i.e.,!0 = R01!0idi)15 endowment.
Its value is allocated in a portfolio of cash, M1t ¸ 0, nominal deposits in
¯nancial intermediaries, D1t, and holdings of the real asset, at ¸ 0. In
the intermediate period of his life, the agent faces the following budget and cash-in-advance constraints:
M2t+ D2t+ pt Z 1 0 c1t · M1t + D1tIt+ pt!1 (4) M1t ¸ pt Z ° 0 c1t (5)
where It is the nominal return on (positive) deposits. Notice that we
already imbedded in these de¯nitions the fact that all goods face the same prices, as well as the fact that the agent has no interest in purchasing two-period assets in the intermediate period of his life. Finally, in the last period of his life, the agent faces constraints
pt+1
Z 1
0 c2t · M2t + D2tIt+1+ pt+1atR
2 (6)
Agents can also borrow from ¯nancial intermediaries. However, an agent borrowing from a ¯nancial intermediary faces a higher interest rate. Such spread corresponds to ¯nancial intermediaries costs, which are discussed below. In the class of equilibria that we study agents do not borrow. Notice that generations overlap for two periods. When generation t-1 decides how much to consume of respectively cash and credit goods (i.e. how to allocate the endowment !1), generation t gets an endowment !0
and decides how much to deposit and how much to invest in real assets.
parameter.
15For simplicty of exposition, we will denote integrals simply as R1
3.1.1 Financial intermediaries
In the model ¯nancial intermediaries accept loans from households, which are repaid at the end of each period at a market interest rate, and pur-chase assets. Alternatively, the purpur-chase of assets can be viewed as loans to private ¯rms that pay back {after two periods{ a real return. Finan-cial intermediaries also receive new cash injections from the monetary authority16. The balance of ¯nancial intermediaries, in absence of money
injections, can be written as:
Dt+1 = ptabt+1 (7)
where ab
t+1 denotes assets in the hands of banks, dt+1 = Dpt+1t denotes
deposits in real terms and Dt = D1;t + D2;t¡1; i.e. total deposits in
period t ¡ 1 are given by the sum of generation t ¯rst period deposits and generation t ¡ 1deposits in their intermediate period.
We consider the following ¯nancial intermediation technology. First, ¯nancial intermediaries can obtain a two-period return (R + µ1)2 from
(borrowing to) private ¯rms. µ1 ¸ 0 denotes the technological advantage
of ¯nancial intermediaries with respect to households. Second, ¯nancial intermediaries can transform a two-period asset into a one-period asset, with return (R+µ1) at a real cost µ2+µ3, where µ2 corresponds to the cost
of making the asset more liquid and µ3 to the cost of handling the one
period asset. In other words, the ¯nancial intermediation technology gen-erates one-period assets with a real return (R¡µ), where µ = µ2+µ3¡µ1,
from the existing two-period assets. The relative e±ciency of di®erent ¯nancial communities will be represented by di®erences in µ. The cash °ow of ¯nancial intermediaries (CF) can, therefore, be written as:
CFt = ptabtR ¡ ptabt+1+ Dt+1 ¡ DtIt ¡ ptabtµ (8)
16For simplicity we do not include government bonds into ¯nancial intermediaries'
balance sheets. This can be done without any di±culty (the standard non-arbitrage conditions will equate the returns of di®erent assets in circualtion) and will allow for government's open market operations.
Since there is free entry in the ¯nancial intermediation sector, the zero pro¯t condition implies that:
ab t(R ¡ µ) = pDt t¡1 pt¡1 pt It ´ dtR d t i.e., Rd
t = R¡µ, where Rdt is the one-period real return on (real) deposits.
As we said, households can borrow from ¯nancial intermediaries, signing one-period debt contracts. In such a case, they will face the nominal rate It + ¼tµ3. We assume that µ1 ¸ µ2 which guarantees that,
even when µ < 0, households will not borrow to ¯nance the purchase of assets, since Rd
t +µ3 = R+µ1¡µ2 ¸ R; the last inequality following from
our assumption.
3.1.2 Monetary policy
We consider a very simple class of monetary policies. At the begin-ning of the initial period 0 agents of generation 0 are endowed with per-capita money holdings of M1 and agents of generation ¡1 with
per-capita money holdings of M2. Money supply is constant thereafter,
al-though we will consider the experiment of unexpectedly increasing (de-creasing) the money supply by Xt+1in period t. This is done through
¯nancial intermediaries. In such a case, their consolidated balance sheet is Dt+1 + Xt+1 = ptabt+1. That is, ¯nancial intermediaries can purchase
(or sell) assets with the proceeds (the claims) of the Central Bank and return, the following period, (Dt+1 + Xt+1)It+1 to depositors. To
main-tain the deterministic nature of our model we will only consider \once and for all surprises."
3.1.3 The initial period
Notice that in our economies there is not enough to characterize the ini-tial distribution on money holdings, we must also characterize the iniini-tial distribution of assets and deposits. We assume that at the beginning of the initial period agents of generation 0 have real claims in ¯nancial in-termediaries of d1;0 giving them a real return d1;0Rd0. Similarly, agents of
generation ¡1 start period 0 endowed with assets a¡1and deposits d2;¡1,
giving them returns a¡1R2and d2;¡1Rd0, respectively. Finally, ¯nancial
intermediaries start period 0 endowed with ab
¡1assets and satisfy their
commitments on initial deposits d0 = d1;0 + d2;¡1. As we will see,
sta-tionary equilibria can be easily characterized; however, their existence requires an appropriate initial distribution of assets and deposits. For example, we will consider economies where a¡1 = 0 and economies where
d2;¡1 = 0. Alternatively, it can be shown that, given an initial
distri-bution of assets and deposits, the economy converges to a stationary equilibrium from period one on.
3.2 Monetary equilibria in a closed economy
A monetary equilibrium is achieved, for a given initial distribution (M1 ; M2; d1;0; d2;¡1; a¡1; ab¡1), when there are prices (p0;f¼t; Itg1t=1), such
that (i) ¯nancial intermediaries choose asset holdings and supply de-posits, fab
t; Dtg that maximize pro¯ts, under a free-entry condition;(ii)
households choose consumptions and portfolios fc1;t; ~c1;t; c2;t; ~c2;t;
M1;t; M2;t; D1;t; D2;t; atg17 that maximize their utility subject to their
budget, and cash-in-advance, constraints and, ¯nally, (iii) all markets clear. In particular, feasibility in the goods market requires that:
°c1;t+(1¡°)~c1;t+°c2;t¡1+(1¡°)~c2;t¡1+at+1+abt+1 = !0+!1+at¡1R2+abtRdt
(9) In order to characterize equilibria, notice that from the ¯rst order condition of the households maximization problem we obtain di®erent solutions depending on whether assets returns dominate deposits or vice-versa because depending on the sign of µ agents will decide to directly purchase assets (if µ > 0), in which case they will not hold second period deposits (i.e., D2;t = 0), or they will put all their savings into
¯nan-cial intermediaries (i.e., at = 0 if µ > 0). To distinguish among these
17Since consumers decide to consume the same quantities of all the cash goods of one
period, and similarly for credit goods, we denote by c1;t the generation t consumtion
of cash-goods in their interemediate period and ~c1;t the consumption of credit goods
economies, we will denote by economy A, an economy where Assets re-turns dominate deposits and by an economy B one where consumers prefer Banks to the stock market as a way to channel their savings.
In an economy of type A (µA > 0), we get the standard condition
equating the marginal rate of substitution between cash and credit goods (of period one) to the nominal interest rate (the cost of assigning part of the portfolio to an intermediary is the lost liquidity of not holding cash and the gain is the interest that can be used for future purchases):
u0(c 1;t)
u0(~c1;t) = Itd (10)
where, from now on, ~c denotes a credit good and c a cash good. However, for period 2 we get:
u0(c 2;t) u0(~c2;t) = It+1d · R R ¡ µ ¸2 (11) On the other hand, in an economy of type B (µB · 0), we get the standard
condition for both periods: u0(c
k;t)
u0(~ck;t) = It¡1+kd ; k=1,2 (12)
We obtain the following intertemporal Euler equations, respectively for economy B and economy A:
u0(~c
1;t) > ¯u0(~c2;t)Rt+1d (13)
u0(~c
1;t) > ¯u0(~c2;t)R2(Rdt)¡1 (14)
Furthermore, as we have seen, competition in the ¯nancial intermediation sector implies that Rd
t = R ¡ µ:
To simplify the analysis, we consider the case of a log utility: u(c) = log(c):With a logarithmic utility function demands take a simple form.
Let W = !0+!1(R¡µ)¡1
(1+¯) , then in economy A generation t has the following
demands
c1;t = WA¼¡1t ; ~c1;t = (R ¡ µA)WA; c2;t = ¯(R ¡ µA)WA¼t+1¡1
~c2;t = ¯R2WA; d1;t = !0 ¡ [(1 ¡ °A)¯ + °A]WA; d2;t = 0;
at = (1 ¡ °A)¯WA; m1t = °AWA and m2t = °A¯(R ¡ µA)WA
Substituting for consumptions, assets and deposits expressed in the feasibility constraint (9) we obtain an equation in one variable, namely the in°ation rate:
M(¼¡1
t ¡ 1) = 0 (15)
where MA = °AWA[1 + ¯(R ¡ µA)]: Notice that for µA 2 (0; R); (15) has
a solution ¼t = 1, for t ¸ 1, showing that there is a unique monetary
equilibrium which is stationary from period one on.
Similarly, for economy B we obtain the following demands c1;t = WB¼t¡1; ~c1;t = (R ¡ µB)WB; c2;t = ¯(R ¡ µB)WB¼t+1¡1;
~c2;t = ¯(R ¡ µB)2WB; d1;t = !0 ¡ °BWB; d2;t = (1 ¡ °B)¯(R ¡ µB)WB
at = 0; m1t = °BWB and m2t = °B¯(R ¡ µB)WB
and (15) also characterizes the equilibrium in°ation rate, ¼¤
t = 1, t ¸ 1:
3.3 Open economies with segmented ¯nancial
sec-tors
If an economy A and an economy B have a common market, but ¯nancial disparities are maintained and -consistently with the well known \home bias puzzle"- consumers tend to use their home ¯nancial institutions, then the situation is similar of that of two independent closed economies. To see this, consider a °exible exchange regime within the countries and that the cash-in-advance constraints must be satis¯ed with the domestic
currency. Furthermore, assume that, in spite of the single market, there is a cost µ4 from operating across borders, such that µB + µ4 > µA (and
¯nancial intermediaries maintain the same domestic cost structure with no arbitrage opportunities). Then, as long as ¼¡1
Bn < (R ¡ µA) and ¼¡1An <
(R ¡ µB) , n = t; t + 1, generation t demands are as in the close economy
case and monetary equilibrium in°ation rates are solutions to MA(¼At¡1¡ 1) + MB(¼¡1Bt ¡ 1) = 0
In particular, the stationary solution is ¼At = ¼Bt = 1 de¯nes a monetary
equilibrium for the °exible exchange regime. Notice, however, that there is a continuum of equilibria given by
¼¡1 At ¡ 1 ¼¡1 Bt ¡ 1 = ¡ MB MA
satisfying the above restrictions on asset return dominance. These solu-tions, however, involve a trade imbalance, and a corresponding perma-nent devaluation of one of the currencies. We will focus in the stationary equilibrium that parallels the closed economies case.
3.4 Monetary Union equilibria (with segmented
¯-nancial sectors)
We ¯nally consider the case in which countries A and B form a monetary union, but \national," or \regional," disparities persist. That is, \trans-national" (or \trans-regional") ¯nancial transactions are subject to the cost µ4. We can also consider that, even if all consumers in the
mone-tary union can satisfy their cash-in-advance constraints with the common currency, there may still persist di®erences regarding the range of goods that can be purchased with credit; that is, °A and °B may di®er. As in
the °exible exchange regime with segmented ¯nancial markets, demands are as in the closed economies case. In particular, monetary equilibrium in°ation rates for the MU are solutions to
As in the case were both countries are separate, stationary output will di®er across countries even if they have the same underlying (as-set) technologies, endowments and preferences, but they maintain their di®erences regarding the e±ciency of the ¯nancial intermediation sector.
4 Unexpected monetary shocks
We now consider a monetary expansion [contraction] taking the form of a once-and-for-all monetary injection [absorption] Xt+1 in period t. We
consider ¯rst the case of independent countries (which also characterizes the stationary equilibrium of the common market with °exible exchange rates) and then the case of a monetary union. As it is well known, the e®ects of monetary policies (in models of limited participation and in real economies) depend on the \when and how" monetary interventions take place. By a monetary injection in period t we mean a unexpected monetary intervention that takes place after period t decisions have been made. In our model, the monetary injection is done through the ¯nancial intermediaries, which have the following consolidated balance sheet
Dt+1 + Xt+1 = ptabt+1
That is, ¯nancial intermediaries purchase [sell] assets (make loans) and the proceeds are paid back to the depositors who {on aggregate- receive a return (Dt+1+Xt+1)I: The e®ects of an identical monetary shock will be
di®erent depending on the type of ¯nancial structure; i.e., whether the economy is a type A economy, a type B economy or a monetary union (of a country of type A and a country of type B). In particular, we are interested in how prices (i.e., nominal interest) and portfolio allocations change and the e®ect of these changes on consumption and output. We can distinguish three types of e®ects: (i) an income e®ect (due to the fact that only people holding deposits get a share of the shock); (ii) an e®ect through di®erent portfolio choices, and (iii) a pure liquidity e®ect (due to di®erent °0s).
In a closed economy the equilibrium condition in period t is M(¼¡1
t ¡ 1) + Xpt+1 t = 0
which implies that
¼t = 1 + Mzt
where zt = Xpt¡1t+1. If Xt+1 > 0, i.e. if we consider a monetary
expan-sion, then there will be a contraction of cash goods in period t a®ecting generations t¡1 and t. In economy A; generation t+1, the only one hold-ing deposits, revises its decisions knowhold-ing that will be getthold-ing a higher (lower) return from their deposits than the one originally foreseen. Let ~c0
1;t+1 be the variation on the consumption of credit goods (i.e., 0 denote
variations). we have that generation t + 1 shares the extra returns from his deposits, d1;t+1, xt+1(R ¡ µA); as follows:
~c01;t+1 = xt+1(1 ¡ °R ¡ µA A+ ¯); m 0 2;t+1 = ¯xt+1(1 ¡ °R ¡ µA A+ ¯) and d02;t = ¯(1 ¡ °A)xt+1(1 ¡ °R ¡ µA A+ ¯)
Notice that after a monetary shock, an agent of generation t + 1 would like to change his portfolio, but, in economy A, the assets, at, are not
liquid and, therefore, the agent must deposit or borrow from the bank (a less attractive intermediation technology). When he saves (i.e. xt+1 > 0)
this results in ~c0
2;t+1 = ¯(R ¡ µA)d02;t, while when he borrows in ~c02;t+1 =
¯(R ¡ µA + µ3)d02;t. These costs of readjusting the portfolio are a crucial
distinct feature of economy A:
If instead the economy that experiences the Xt+1shock is of type B
, both generations, t and t + 1, holding deposits, will change their credit-goods consumption. Let ® = di;t+1
dt+1 be the share of deposits corresponding to generation t+1. Then, ~c0
2;t = (1 ¡®)xt+1(R ¡µB) and generation t+1
will revise their consumption plans as in economy A (except that they only receive xt+1(R¡µB)). The di®erence, however, is that since in
econ-omy B; d02;t > 0, and agents always want to have positive consumption of
intermediaries following a monetary contraction in economy B. In other words, in economy B the adjustments, following a monetary shock, are less costly than in economy A (agents use the same intermediation tech-nology with the same returns as when they where making consumption plans in their initial period).
The adjustments of generation t + 1, however, result in an excess supply (demand) in the goods market in period t+1 (due to m02;t+1 6= 0), resulting in a variation of prices given by
¼t+1 = · 1 + 1 ¡ °¯°A A+ ¯ xt+1 MA(R ¡ µA) ¸¡1
in economy A and, similarly, in economy B ¼t+1 = · 1 + 1 ¡ °¯°B B + ¯ ®xt+1 MB (R ¡ µB) ¸¡1
If both countries form a monetary union but ¯nancial structures remain the same and households use their countries' ¯nancial intermedi-aries, households will adjust their portfolios in the same manner as they do when countries are separate. There is, of course, an important di®er-ence in that there is a unique price reaction for both countries. That is, with a shock Xt+1, in°ations in period t and t + 1 are, respectively,
¼t = 1 + M zt A+ MB and ¼t+1 = · 1 + µ ¯°A 1 ¡ °A + ¯(R ¡ µA) + ®¯°B 1 ¡ °B + ¯(R ¡ µB) ¶ xt+1 MA+ MB ¸¡1
Notice that if countries are of the same (endowment) size, the country with a larger ° will absorb most of the shock in consumption, which will result in a redistributive e®ect in period t (and t + 1).
4.1 The quantitative e®ect of a money shock in our
economies
The real e®ects of monetary shock can be quite di®erent depending on the type of ¯nancial structure that a country has or wether countries are
integrated in an heterogeneous monetary union or not. Even if our aim is not to exactly mimic observed economies, the parameters underlying ¯gures have been chosen as to approximate Economy A with France and Economy B with Germany (see Table 6)18.
Table 6 here
Figure 1a illustrates the e®ects of a monetary contraction on output (and Figure 1b for consumption) when economies A and B are indepen-dent (the shock is in period 6). As it can be seen, the e®ect on output is higher and slightly more persistent for economy A than for economy B. In other words, the economy (Germany) with a higher cash/deposit ratio and indirect ¯nance prevailing over direct access to the market (µA>µB);
because of lower transaction costs and higher e±ciency, is partially pro-tected from the e®ects of a monetary restriction. Figure 2a, reproduces the same experiment for a Monetary Union (and a shock twice the size). As in the closed economies case, at the time of the shock, aggregate output does not change, but there are important redistribution e®ects between countries due to di®erent cash/deposit ratios, output of econ-omy B is increased at the time of the shock, indicating that in relative terms economy B is better o®. In the next period, however, aggregate output decreases and also output of economy B drops, even though still less than output of country A. This pattern can explain, at least to a certain extent, di®erences in preferences for a tighter monetary policy for countries of a B type (in relative terms economy B is better o® with monetary tightening and worst o® with monetary expansion).
In order to isolate the e®ect of large di®erences in the cash/deposit ratio we replicate the same exercise with the same ° for both coun-tries. In other words, we concentrate on income and assets e®ects. If we take again autarchic countries we see that, as in the case with di®erent cash/deposit ratios, in economy A the output e®ect is larger (Figure 3).
18The two main di®erences are in the degree of e±ciency of the banking sector
-approximated in our calibration by the parameter µ; substantially higher in Germany than in France (the banking sector has a higher technological advantage with respect to households and the transaction costs are lower, Cf also Rodriguez, 1998)- and in the cash holding of domestic currency, i.e the parameter °;again higher for Germany.
When we consider the monetary union case, there is no redistribution of consumption, but there are still output di®erences (Figure 4). Here total output decreases but less than it would had been for an economy A in isolation. In other words, endogenous preferences for monetary policy may be diverse.
Figure 1b and 2b show the behavior of total consumptions, it in-creases at the time of a monetary contraction (as expected) because of cash in advance constraints, to decrease in the subsequent periods. Total consumption of economy A is more volatile, than that of economy B, when economies are independent, but less volatile when countries joint a monetary union. This is due to di®erences in ° (with equal ° the pe-riod t reaction is the same in both countries and, as in ¯gures 1b-2b, the -negative- e®ect is more persistent in economy A).
Finally, ¯gure 5 shows how prices (i.e., gross in°ation ¼) react to a monetary contraction, when countries are independent or in a monetary union. As it can be seen, our model does not predict a \price puzzle", as it has been observed in some European economies (see, for example, Sims, 1992). Following a monetary contraction prices fall (the \puzzle" being that it seems to ¯rst increase), to then experience a small increase, before returning to their stationary level.
5 The calculated VAR for France and
Ger-many
The issue of empirical testing the existence of possible di®erences in the impact of monetary policy on output and prices in European countries is not easy and far from having a de¯nite answer (see Dornbusch et Al, 1998). The case for asymmetric impact of a monetary shock is easy to make, since, as we have documented in Section 2, there are marked cross-country di®erences in the ¯nancial structure (e.g. mix of direct and indirect ¯nance, share of ¯xed and variable rate contracts, degree of indebtedness etc.). But di®erences in the ¯nancial structure do not translate easily into clear-cut results and, in any case, they prompt forces
which are likely to o®set each other (see Gennari and Giovannetti, 1998 for a discussion). Furthermore, EMU represents a change in regime, di±-cult to account for properly (we are back to \Lucas's critique"). Against this background, many studies have tried to identify cross-country dif-ferences in monetary policy transmission19, at least in the current set-up
(i.e. before the start of EMU), but no consensus seem to exist on the extent or nature of possible di®erences. More precisely, it seems that very di®erent results can be obtained for the same country using di®er-ent models and that the ranking of the strength of a common monetary shock on output is not consistent across di®erent studies.
In what follows, we do not enter into the debate of what is the best way to estimate the e®ect of a common monetary shock in di®erent countries (see BIS, 1995) nor what is the best identifying scheme, even though we are aware of the possibility of getting di®erent results when using di®erent methods or identi¯cation schemes. Our aim is simply to see whether the implications of our theoretical model are consistent with the actual response of output to monetary shocks - i.e.e that di®erences in the e±ciency of the ¯nancial structure and banking system a®ect-ing consumers' portfolio choices and ¯rms' ¯nanca®ect-ing re°ect in di®erent output response to interest rates shocks, higher in the country with the least e±cient banking system. To this aim, we estimated VAR, which have the advantage of avoiding the need for a complete speci¯cation of a structural model20. In principle, to evaluate correctly the e®ects of
mon-etary policy, we should solve an identi¯cation problem: policy actions which are endogenous responses to current developments in the economy must in fact be separated from exogenous policy actions. Only when the
19Di®erent methods have been used to this purpose: national and multi-country
econometric models, structural VAR with their impulse response function, single equation models among others. Cf. Britton and Whitley, 1997 for a comprehen-sive survey; Dornbusch et al, 1998, and Ramaswamy and Sloeck, 1997 for estimation on groups of countries.
20There is an extens literature on pro and cons of VAR to study the transmission
mechanism of monetary policy well summarized in Christiano, Eichenbaum, Evans, 1998. Also there are problems related to the so-called price puzzle, pointed out by Sims, 1992 and suggestions to include import price to avoid it and so on (see also Bagliano e Favero, 1997).
latter are identi¯ed, the dynamic analysis of the VAR system can give reliable information on the monetary transmission mechanism. In the following, we use the Choleski decomposition21 for a parsimonious VAR
speci¯cation which includes 3 endogenous variables: output ( industrial production), prices, and interest rates. We estimate the model over the period 1973-9722 for France and Germany and here we only report the
impulse response functions23, i.e. the responses of output, prices and
interest rates to unexpected shocks to interest rates.
All our variables are non-stationary (see Table 7): output (indus-trial production24) seems to be integrated of order 1 both in levels and
logarithms, while CPI is I(2) (i.e. in°ation is I(1)). Hence, we used in°ation in our VAR estimates.
Table 7 here
For both countries, the VARs are speci¯ed with 2 lags; in our pre-ferred speci¯cation, we add a trend, a set of orthogonal seasonal dummies
21In a 3 variable system this means that the last variable in°uences the ¯rst two,
without feedbacks from them and the second variable in°uences the ¯rst without feedbacks from it.
22Data are described in the Appendix. Unit root tests are done using PCGive.
Estimations are done using the package E-views, version 2.0 and PCFIML. The period corresponds to the longest available with fairly homogeneous data. We have also reduced the period of estimation to consider only the ERM period (1979-97) and results do not change. The same applies when exogenous variables are added to the estimates, such as exchange rate developments, raw material prices etc. or dummies to account for the 1992 ERM crisis and the 1993 enlargement of °uctuation bands.
23Even though impulse responses are not a valid model selection criteria, because
they are determined by the chosen methodological framework in which a model is built (i.e. the imposed identifying restrictions, its speci¯cation and its estimation method), they are widely used in the empirical literature because they easily con-vey the message and provide a simple graphical assessment of the di®erences in the trasmission mechanism.
24Industrial production is preferred to output in the empirical literature, and the
e®ects of a monetary shocks are more visible; however here we report the impulse responseof output for consistency with our theoretical model where we have con-sumption and assets rather than production. Cf. Simms, 1992; Mojon, 1997 amongst others for discussion on the use of industrial production and Gennari and Giovannetti, 1998, for VAR using the same data set and methodology but industrial production instead of output.
(CPI are not adjusted) and some country dummy (for further details, see Appendix and Gennari and Giovannetti, 1998).
Graph 6 and 7 show the impulse responses to a standardized mone-tary shock together with 95% con¯dence intervals. In Germany (output) bottoms out about ten quarters after the contractionary shock, and a similar pattern is observed in France. The numerical e®ect, however, is higher in France (around -0.004 against -0.002) than in Germany25. This
implies that Germany is partially protected from a monetary tighten-ing (at the same time it bene¯t less from a monetary expansion), with consequences on the preferences for monetary policy.
These results are very stable in the case of France. Di®erent mea-sures of interest rates (Pibor, Tbill rate), di®erent sample sizes, inclusion of a dummy variable to account for the EMS crises, inclusion of import prices to deal with the price puzzle did not change the response of out-put in any dimension (shape, numerical size, lags) while impacting on the price response to an interest rate shock26.
As for Germany, however, the results seem to be more sensitive to the sample size, most likely because German Uni¯cation represents a change in regime which is di±cult to account for when the more recent period has a higher weight27. Interesting enough, when a shorter sample
25If industrial production is used instead of output, the numerical values are
respec-tively -0.008 for France and -0.005 for Germany, so the results are con¯rmed. When using the output data a step dummy and an impulse dummy have to be included for Germany in order to account for the break in the series due to German Uni¯cation.
26As most of the empirical studies we have reviewed, we found weak evidence of
a price puzzle, i.e. a perverse response of prices. The inclusion of import prices in the VAR reduces the positive response of prices to a monetary contraction, without eliminating it completely. Clarida and Gertler (1996) provide two explanations for the price puzzle: either the magnitude of an interest rate rise which represents a policy shock is not strong enough to have a decreasing impact on in°ation, or there is an identi¯cation problem in the sense that the Central Banks have additional news about in°ation which are not captured by the model.
27We replicated our exercise with the data set kindly provided by Ramaswamy
and Sloeck, 1997. Again, the output response of Germany changes with di®erent sample sizes while that of France is very stable. In particular the standard errors for Germany become very large on a shorter sample. The price response, not reported in
size is selected (e.g. 1983-97), the e®ect of the shock on German output is substantially weaker (not di®erent from zero) and the standard errors much larger.
The e®ects of the shock are transitory in both countries but seem to be slightly more persistent in France (as in the computed responses from our model). Overall, the estimated impulse response for France and Germany have a shape very similar to the theoretical response calculated from our model: the e®ect of a monetary shock in the current situation is di®erent in the two countries and has a bigger impact in France where agents are more illiquid. The asymmetry can have important conse-quences for the behavior of the European Central Bank, at least up to when(if) the ¯nancial structures in Europe will converge.
6 Conclusions
The focus of the debate on Monetary union has been so far mainly on "real convergence". Real convergence is very important to achieve con-sensus on harmonization of policies in a MU. However, di®erences in the ¯nancial structure can be crucial to achieve consensus on the -by de¯nition- harmonized monetary policy in EMU. Cross-country e®ects of a common monetary policy can be di®erent as a result of di®erences in ¯nancial structures and in the transmission channels of monetary pol-icy. While these issues are often discussed, they had not been appropri-ately modeled and quanti¯ed. This paper is novel in these regards. First describes the underlying di®erences across the main EMU countries, sec-ond provides a theoretical model accounting for these di®erences, where is possible to study the e®ects of an unexpected monetary shock, and, third, provides new estimates of the e®ects of a monetary shock in France and Germany. Such estimates are consistent with the predictions of the theoretical model.
Our work suggests that there are possibilities of con°icts over mon-etary policy, at least in the early stages of EMU, even if countries'
resentatives in the ECB share the same principles over monetary pol-icy and there are no cyclical di®erences across countries. It is to be expected, however, that ¯nancial sectors will be progressively less seg-mented, which, according to our theory, will result in more homogeneous e®ects. The European experience, since 1992, and the US experience, shows, however, that such convergence may be slow. This can be im-portant for the EMU since policy consensus will be crucial in its ¯rst stage.
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[36] Sims C.A., 1992, Interpreting the macroeconomic time series facts: the e®ects of monetary policy, European Economic Review, 36, 975-1011;
[37] Taylor, John, the monetary transmission mechanism: an empirical framework, Journal of Economic Perspectives, 9, pp.
7 Tables
Table 1: Structure of Financial markets, 1996
Market capitalization Trading volume
FIR BIR (% GDP) % GDP France 42.4 73.8 38.9 63.5 Germany 52.8 80.2 29.6 33.3 Italy 39.9 70.3 21.7 8.6 UK na na 149.9 66.1 EU na na 53.0 38.5
Source: Bundesbank, Monthly Report, January 1997 and European Economy, Supplement A, Economic Trends, n.12, December 1997. FIR stands for Financial In-termediation Rate and is Financial assets of FI% total assets; BIR stands for Banking Intermediation Rate and is Fin. assets of Banks%of Fin. Assets of Fin. sector.
Table 2: Financial assets of Households (as proportion of gross ¯nancial assets)
1980 1994
Banks bonds equities inst.inv. Banks bonds equities inst. inv. France .59 .09 .14 .07 .32 .04 .32 .29 Germany .59 .12 .04 .17 .45 .14 .06 .28
Italy .58 .08 .1 .06 .29 .2 .24 .09
UK .43 .07 .12 .3 .26 .01 .12 .54
Source: Davis, 1996.
Table 3: Corporate sector balance sheets, 1980 and 1994 (as proportion of gross ¯nancial assets)
1980 1994
bonds equit. loans. bonds equit. loans. France 0.4 .34 .28 .03 .70 .28 Germany .02 .2 .52 .08 .25 .50 Italy .04 .52 .43 .03 .46 .44 UK .02 .37 .22 .001 .65 .12
Table 4: Ownership of listed shares by sector,1995
Households Non ¯n. corp. Public tot non-¯n sector Fin. Inst. Foreign
France 19.4 58.0 3.4 80.8 8.0 11.2
Germany 14.6 42.1 4.3 61.0 30.3 8.7
Italy 17 32 28 77 19 5
UK 29.6 4.1 0.2 33.9 52.4 13.7
Source: Deutsche Bundesbank Monthly Report, January 1997 and OECD Fi-nancial Markets Trends, November 1995.
Table 5: Monetary Aggregates, 1995
France Germany Italy UK
cash/M1 9.1 29.1 15.9 4.7
cash/M2 7.8 18.9 8.1 na
cash/M3 4.7 11.8 na na
Per capita currency holding (US $) 850 1983 1066 575
Sources: Banque de France, Banca d'Italia and Deutsche BundesBank, annual reports and OECD Financial Statistics.
Table 6: Parameters of the simulations
!0 !1 ¯ ° R µ1 µ2 µ3 R ¡ µ
Country A 8 6 .996 0.78 1.05 .018 .01 .012 1.046 Country B 8 6 .996 .189 1.05 .02. .005 .005 1.06
Table 7:Unit root tests a) France
test statistic test statistic
in° rate levlogs ADF(1)ADF(1) -1.521-2.788 ¢¢levlogs ADF(1)DF -4.806**-3.968*
gdp lev logs ADF(4) ADF(2) -2.572 -2.18 ¢lev ¢logs ADF(3) ADF(1) -3.45* -4.493** import prices lev logs ADF(1) ADF(1) -2.705 -2.628 ¢lev ¢logs DF DF -5.249** -5.646** ind. prod lev logs ADF(2) ADF(2) -2.392 -2.385 ¢lev ¢logs ADF(1) ADF(1) -4.178** -4.285**
call m rate lev ADF(5) -4.512** ¢lev ADF(5) -3.651**
int.rate
3mth T.Bills levels ADF(1) -3.081 ¢levels DF -6.651**
PIBOR
3 months levels ADF(1) -3.073 ¢levels DF -6.981**
b) Germany
test statistic test statistic
gdp levlogs ADF(1)ADF(4) -2.116-2.278 ¢lev¢logs DFADF(3) -8.248**-3.01* in° rate (cpi) levlogs ADF(1)ADF(4). -1.521-3.54* ¢lev¢logs ADF(1)DF {9.171**-4.46** import
prices levlogs ADF(1)ADF(1) -3.25-3.55* ¢lev¢logs DFDF -4.21**-4.18** w. mkt p. (raw mat). lev logs ADF(3) ADF(3) -3.49* -3.66* ¢lev ¢logs ADF(2) ADF(2) -3.17* -3.25*
call m rate lev ADF(5) -2.077 ¢lev ADF(4) -5.97**
LT int.rate
(7-15 y) lev ADF(3) -2.32 ¢lev ADF(2) -3.51*
Appendix I:Data Sources
Data are obtained from IFS and Analytical Database of the OECD. The period used is 1973 ¯rst quarter, 1997 fourth quarter. Output is in logs and is seasonally adjusted. The series on real GDP is de¯ned in national currency and is obtained from the OECD database (GDPVol). The series on consumer price index is obtained by IFS (n. 64 for each nation). The nominal interest rate is the call money rate and is also from IFS. We also used industrial production from OECD database, UN commodity price index (IFS), DM- dollar exchange rate series (IFS), French franc- DM exchange rate series (IFS). For Germany a step dummy for GEMU was used (0-1) and an impulse dummy for changes in the mean in 1991. For France a dummy accounting for the oil crisis and the ERM crises.
0 2 4 6 8 10 12 0.993 0.994 0.995 0.996 0.997 0.998 0.999 1
Output response to a monetary contraction (Indep. co.)
0 2 4 6 8 10 12 0.995
1 1.005 1.01
Consumption response to a monetary contraction (Indep. co.)
0 2 4 6 8 10 12 0.993 0.994 0.995 0.996 0.997 0.998 0.999 1
Output resp. to a mon. contr., equal gammas (Indep. co.)
0 2 4 6 8 10 12 0.994 0.995 0.996 0.997 0.998 0.999 1 1.001 1.002
Output response to a monetary contraction (Monet. Union)
0 2 4 6 8 10 12 0.99 0.995 1 1.005 1.01 1.015
Consumption response to a monetary contraction (MU)
0 2 4 6 8 10 12 0.993 0.994 0.995 0.996 0.997 0.998 0.999 1 1.001
Output resp. to a mon. contr., equal gammas (MU)
0 2 4 6 8 10 12 0.7 0.75 0.8 0.85 0.9 0.95 1 1.05
Economy A: * Economy B: + MU: o
-0.010 -0.005 0.000 0.005
5 10 15 20 25 30 35 40 45 50 55 60
Response of LGDPVOL to CALLMONEY
-0.0015 -0.0010 -0.0005 0.0000 0.0005 0.0010 0.0015 0.0020 5 10 15 20 25 30 35 40 45 50 55 60
Response of INFL to CALLMONEY
-1.0 -0.5 0.0 0.5 1.0 1.5 5 10 15 20 25 30 35 40 45 50 55 60
Response of CALLMONEY to CALLMONEY
